Up for Review: 401(k) Industry

Americans' 401(k) retirement plans are starting to face scrutiny -- of a kind that previously helped to reshape the mutual-fund business and many practices on Wall Street.

In recent months, a series of lawsuits has raised questions that longstanding business practices in the industry may represent illegal forms of collusion. In the past few weeks, Congressional Democrats -- after winning the majority in November for the first time in years -- are calling for hearings into whether current laws do enough to protect 401(k) investors. A November report by the Congressional Government Accountability Office said some practices "may not be in the best interest" of investors.

At the same time, the summer's landmark pension-reform law is encouraging employers to take a more active and even paternal role in their employees' 401(k) plans by offering in-depth investment advice and other tools designed to encourage people to save. Previously, companies were discouraged from taking these steps for fear of being sued should the investments go wrong.

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As a result of these forces, 401(k) plans could receive their most significant overhaul since coming into existence a quarter-century ago. Fees to investors could be reduced, and companies could be forced to do a better job ensuring investors receive the most bang for their retirement dollar.

Since being created in 1981 as a way to sock away dollars tax-free for retirement, 401(k)s have supplanted traditional pension funds as the primary way most Americans save for retirement. Some 47 million participants have $2 trillion in money invested in the plans.

Critics increasingly are complaining about poorly disclosed financial arrangements -- known as "pay-to-play" deals -- that not only have the potential to influence which investment options are offered in a given plan, but also have the potential to drive up fees charged to investors.

The pressure for change is occurring at every level of a complex industry: Employers have a legal obligation to run a plan in the best interest of its participants. The money manager has responsibility for the investments, but other companies might have a separate role in keeping investor records and holding the actual securities being bought and sold in the plan. On top of that, sometimes there are outside brokers or consultants paid to help decide which investments go into a plan.

That complexity can breed problems, experts say. "Unfortunately there are [employer] fiduciaries who fell asleep at the switch; there are brokers who will charge excessively high fees; ... and there are plan providers who support all this," says Fred Reish, a Los Angeles attorney specializing in retirement-plan law. "This is all one big ball of wax."

The most direct attack on 401(k) plans -- and similar retirement plans for government employees and teachers called 457 plans and 403(b) plans -- has come in the courts. Several lawsuits allege that commonplace business arrangements between some of the parties are actually illegal.

For example, some mutual-fund companies that run retirement plans will take a portion of the money they collect from investors and use it to pay consultants, who, in turn, recommend which funds are included in a retirement plan. Because some consultants recommend only those fund companies that make such payments, these deals have been dubbed pay-to-play arrangements.

Critics say it can result in participants being offered subpar investments or worse. In November, a lawsuit was filed against Nationwide Financial Services Inc. on behalf of participants in the retirement plan it runs for the Orange County, Fla., sheriff's office. The suit, filed in U.S. District Court for the Southern District of Ohio, alleges that unbeknownst to the plan's investors, money from some of these arrangements paid for meals, trips and entertainment.

Nationwide denies the allegations and says it will fight the suit.

A second common practice alleged to be improper is that big 401(k) plans often will use the same class of mutual-fund shares that small, individual investors use -- even though lower-fee classes of those shares are often available to big investors like these. In addition, certain fees (such as those for record-keeping) are assessed as a flat percentage of assets, which means as an investor's savings grow, more money is being collected from them even though no additional services are provided.

The most recent such suit was filed this month against Fidelity Investments, the nation's largest retirement-plan manager. The case, filed in U.S. District Court in the Western District of Wisconsin, argued that Fidelity charged "unreasonable and excessive" fees and had hidden arrangements that misused participants' money.

Fidelity says that it will fight the lawsuit and that fees its charges are reasonable.

In mid-September, a St. Louis law firm, Schlichter Bogard & Denton LLP, which specializes mainly in personal-injury cases, kicked off the recent spate of suits when it filed in federal court a series of cases (including the Fidelity suit) alleging that the 401(k) retirement plans of some of the country's biggest employers misled and overcharged investors.

Jerome Schlichter, the lawyer overseeing these cases, argues that employers and the companies that run 401(k) plans are failing to live up to a basic legal responsibility: ensuring that their fees are reasonable. "The fees are not being disclosed, and if you don't know what fees are being charged, you can't know if the fees are reasonable."

Meanwhile, Democrats in Congress, armed with the Government Accountability Office study, are looking at revisiting laws governing oversight of the plans. While the scope of the hearings hasn't been decided -- much less what any outcome might potentially be -- the stepped-up interest by politicians is further stirring the pot.

The GAO, in a recent report commissioned by George Miller (D., Calif.) said current rules result in "piecemeal" disclosure and that investors aren't given information that would help them determine whether they were getting a good deal. The GAO also warned against some of the same practices targeted by the lawsuits, saying they may hide conflicts of interest.

The GAO also said the Labor Department, which is responsible for regulating 401(k) plans, hasn't been collecting the kind of information on the plans that it needs to do the job.

Not all changes may come at the barrel of a gun. Laws passed by Congress this summer make it easier for employers to automatically enroll workers in 401(k) plans, increase their savings rates and automatically place them in appropriate stock- and bond-fund investments. These new laws lessen the risk to employers for taking these steps on a worker's behalf.

That is a big change from a few years ago. "It used to be that employers would say, 'We have this 401(k) plan with a great matching program -- now you guys go manage this on your own,'" says Terri Fox, who oversees the 401(k) plan at Texas Instruments. "The pendulum has swung."